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Chapter 12. Performance Evaluation in Decentralized Organizations. Decentralization. Practice of delegating decisions to lower-level managers. LO1: Explain costs and benefits of decentralization. Test Your Knowledge!. The benefits of decentralization include all of the following except:.

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Chapter 12

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Chapter 12

Performance Evaluation in Decentralized Organizations


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Decentralization

Practice of delegating decisions to lower-level managers

LO1: Explain costs and benefits of decentralization


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Test Your Knowledge!

The benefits of decentralization include all of the following except:

  • it forces top levels of management to focus on individual units.

  • it empowers more employees at lower levels of management.

  • it allows for better and more timely decision making.

  • it trains future managers.

Decentralization does not force top levels of management to focus on individual units.


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Organization Structure

  • A responsibility center is the smallest unit of analysis

    • Almost like a mini-business

    • Clearly defined goals and authority

  • We need to put in control systems

    • Induce “right” use of local knowledge

    • Induce coordination & cooperation with other responsibility centers

    • Ideally, a mix of financial (profit, sales) and non-financial (yield, customer satisfaction) measures

  • Incentive structure depends on unit being considered

    • Non-trivial to link performance measures to incentives

LO1: Explain costs and benefits of decentralization


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Aaron Knight,

CEO

Manager,

New Jersey

Region

Manager,

New York

Region

Manager,

Westchester

Region

Staff Assistant

Branches

Branches

BranchManagers

Supervisor

(Copies)

Supervisor (PC)

Copy Center

Staff

PC Center Staff

Typical Organization Structure

LO1: Explain costs and benefits of decentralization


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Kinds of Responsibility Centers

LO1: Explain costs and benefits of decentralization


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Goal: minimize the cost of producing a specified level of output or the cost of delivering a specified level of service

Efficiency of operations is the focus

Examples

Machining, assembly, the entire plant

Human resources, advertising, general administration

Cost Center

LO1: Explain costs and benefits of decentralization


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What can a cost center manager control?

Mix of inputs for a given level of output

Not responsible for final products and service

How should we evaluate them?

Budget-based comparison for financials

Center specific non-financial measures

Cost Center: Duties And Measures

LO1: Explain costs and benefits of decentralization


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Kinds Of Cost Centers

  • Engineered cost center

    • Clear relation between resources consumed and output

      • Machining or Assembly department

    • Flexible budget makes sense here

    • Quality, service, response time are all important Critical Success Factors (CSF)

  • Discretionary cost center

    • No clear relation between resources consumed and output

      • Legal, Accounting, R & D

    • Does not make sense to flex the budget

    • Non-financial measures gain more importance

LO1: Explain costs and benefits of decentralization


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Profit centers aim to both minimize costs and to maximize revenues.

Regional centers

Product line managers

What can these managers control?

Input mix, product mix, selling prices

Profit center typical contains revenue and cost centers

Profit Centers

LO1: Explain costs and benefits of decentralization


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How should we evaluate a profit center?

Budgeted vs. actual profits

Baseline is master budget as manager responsible for output as well

Non-financials are more strategic in nature

Issues to consider include:

If system encourages local profit maximization as opposed to firm-wide profit maximization?

How to price transfers across profit centers?

Profit Centers: Evaluation

LO1: Explain costs and benefits of decentralization


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Investment Centers

  • Aim to maximize the returns from invested capital, or to put the capital invested by owners and shareholders of their organizations to the most profitable use.

    • Large independent divisions in organizations such as Sony, Siemens, Microsoft, and Proctor and Gamble. Decision rights

  • What decisions can managers make?

    • Input mix, product mix, selling prices, capital expenditures

  • How should we evaluate them?

    • Financials focus on Investment performance

      • Return on Investment, Residual Income, Economic Value Added

    • Non-financial measures less important

      • Focus on strategy implementation and long-term potential

LO1: Explain costs and benefits of decentralization


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Performance Evaluation

  • The controllability principle

    • Focus on costs and benefits that reflect the consequences of the actions taken by the decision maker.

      • Sales for marketing manager

      • Costs and quality for production manager

  • The informativeness condition

    • A performance measure is informative if it provides information about a manager’s effort, even if the manager does not have control over it

      • Helps to filter out the noise between effort and the outcome measure

    • Leads to relative performance evaluation

      • Grading on a curve (you cannot control the class average!)

LO2: Apply the principles of performance measurement


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Involves many related decisions

How to reflect decision rights assigned to the responsibility center being evaluated?

What is right time horizon to consider?

How do define the measure?

Is investment measured at gross or net book value, at replacement cost?

Implementation requires more choices

What is the target level of performance?

What is the timing of feedback?

Choosing A Performance Measure

LO2: Apply the principles of performance measurement


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Effective Measures

  • An effective measure

    • Aligns employee and organizational goals.

    • Yields maximum information about the decisions or actions of the individual or organizational unit.

    • Is easy to measure.

    • Is easy to understand and communicate

  • No single measure has all of these characteristics

    • Rely on multiple measures

    • Financial and non-financial

    • Portfolio approach

LO2: Apply the principles of performance measurement


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Short term measures

Focus is on efficiency

Non-financial measures for operational control

Real time, actionable, disaggregate

Variances

Financial impact

Trends and patterns

Long term measures

Focus is on effectiveness

Trend in efficiency

Kaizen

Investments in future

Training

Evaluating Cost Centers

LO3: Rate the performance of cost and profit centers


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Short-term

Less reliance on non-financial measures

Budget- actual comparison

More macro than cost center comparison

Variances for spotting trends and patterns

Long-term

Growth measures

Sales, profit and efficiency

Drivers of future profitability

Non-financial measures

Measuring Profit Centers

LO3: Rate the performance of cost and profit centers


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Three widely used metrics

Return on Investment (and variants)

Residual Income

Economic Value Added

Measuring Investment Centers

LO4: Evaluate the performance of investment centers


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ROI = Income/Investment

We find many variations of the above formula

Income definitions typically used

Operating income, Net Income

Investment definitions typically used

Total assets, total assets - current liabilities

We will use total assets and operating income

The best metric depends on the purpose at hand

Operating income best suited for performance evaluation

Return on Investment (ROI)

LO4: Evaluate the performance of investment centers


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Sample ROI Calculations

LO4: Evaluate the performance of investment centers


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Advantages

Effective summary measure

Size independent (can compare across divisions)

Can decompose ROI into smaller pieces

Criticism

Can foster underinvestment

Favors older divisions because of their smaller asset base

ROI: Evaluation

LO4: Evaluate the performance of investment centers


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ROI: Measurement

We can measure assets at several levels

In general,

Match the definition in the numerator and denominator

Use the measure best suited for decision at hand

Use exit cost for whether to stay in business!

LO4: Evaluate the performance of investment centers


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$7,000,000

1

$7,000,000

2

$8,200,000

3

$550,000

4

1

($7,150,000 + $6,850,000) / 2 = $7,000,000

2

($1,100,000 + $1,300,000) / 2 = $1,200,000

$7,000,000 + $1,200,000 = $8,200,000

3

$7,150,000 + $250,000 - $6,850,000 = $550,000

4


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ROI: Decomposition

  • DuPont Method

  • ROI = Investment turnover * Return on sales

    • Investment turnover = Revenues/Investment

    • Return on sales = Income/Revenues

  • This analysis helps to identify the source of the profit

    • Must be in line with business strategy

    • Suggests corrective action

LO4: Evaluate the performance of investment centers


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0.80

1

.125

2

10%

3

1

$6,400,000 / $8,000,000 = 0.80

2

$800,000 / $6,400,000 = .125

Profit margin x asset turnover = 0.80 x .125 = 10%

3


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Managing ROI

LO4: Evaluate the performance of investment centers


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Test Your Knowledge!

When a company is attempting to increase return on investment (ROI) it should work to:

  • decrease sales.

  • decrease profits.

  • increase costs.

  • decrease operating assets.

Decreasing operating assets will cause return on investment to improve if other relevant factors remain constant.


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Residual Income (RI)

  • Residual Income (RI)

    • RI = Income - (Required rate of return * Investment)

      • Definition of income and investment same as under ROI

      • Required rate of return is the opportunity cost of capital to the company

  • RI is a measure of “additional” value of the project than what is expected

  • RI is a size sensitive measure -- bigger projects with the same ROI may show a greater RI than smaller projects

LO4: Evaluate the performance of investment centers


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Calculating RI

RI has similar measurement issues

Still have to define income and investment

Still have to pick measurement basis (gross / net) for assets

LO4: Evaluate the performance of investment centers


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Advantages

Avoids underinvestment problem present with ROI (Will explore in a few slides)

Intuitive economic interpretation

Disadvantages

Size dependent (larger divisions have larger RI)

Depends on rate used

Residual Income: Evaluation

LO4: Evaluate the performance of investment centers


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RI is size dependent but ROI is not

Can lead to conflicting rankings

But, RI is conceptually superior because it is claimed to lead to better project selection

Comparing ROI and RI

LO4: Evaluate the performance of investment centers


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Project Evaluation: ROI Vs. Ri

LO4: Evaluate the performance of investment centers


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A variation of the residual income concept involving more “careful” calculations

EVA = NOPAT - (WACC [Total assets - NIBCL])

NOPAT = Net operating income after taxes

WACC = Weighted average cost of capital

NIBCL = Non-interest bearing current liabilities

Various adjustments to GAAP to derive economic income

GAAP requires treatment of some items such as R&D expenditures, failed exploration attempts, goodwill that are “inconsistent” with these items being “investments”

Detailed EVA calculations will be covered in an elective class

Economic Value Added (EVA)

LO4: Evaluate the performance of investment centers


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Advantages

Presents true economic picture

Provides managers with information about cost of capital used in their business

Specifies what to measure and how to measure

Disadvantages

More complex calculations as it requires numerous adjustments to GAAP income statements

While used by many firms, not as popular as ROI

EVA Evaluation

LO4: Evaluate the performance of investment centers


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ROI, RI, and EVA calculations are for a single time period (one year)

Many companies use annual bonus plans based on such measures

Could promote investment myopia

Investments may hurt these measures in the short run because benefits realize only in the future years

Using NPV analysis to make investment decisions is consistent with using multi-year RI to evaluate managers’ performances

Choosing Time Horizons

LO4: Evaluate the performance of investment centers


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Divisions transact with each other

Vertical integration

Synergy in operations

Transfer price is a internal price for such transactions

No cash changes hands

What Is A Transfer Price?

LO5: Describe transfer pricing


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Computing product cost

Determine divisional profit and provide economic signal for

Resource allocation

Performance evaluation (support decentralization)

Value due to minority shareholders

Calculate taxes payable in different jurisdictions

Roles often conflict

Demand For Transfer Prices

LO5: Describe transfer pricing


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$243,000

($431,300)

1

2

1

$1,405,600 – [0.18 ($10,450,000 - $245,000)] = ($431,300)

2

$756,000 – [0.18 ($2,500,000 - $650,000)] = $243,000


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Accounting Treatment

LO5: Describe transfer pricing


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Cooperation among divisions

Increase “surplus”

Maximize corporate profit

Sum of divisional profits

Competition among divisions

Dividing surplus is “zero sum”

Focus on divisional profit maximization

Theoretical solution can be derived (see appendix) but is not practically feasible

Conflict In Transfer Pricing

LO5: Describe transfer pricing


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Market-based transfer pricing

Price in the intermediate product market

Cost-based transfer pricing

Variable cost-based transfer price

Unit variable cost plus a markup

Full-cost based transfer price

Full cost plus a markup

Negotiated transfer price

Practical Solutions

LO5: Describe transfer pricing


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Market based prices

Preferred when available

30-50%

Cost based prices

Full cost is common

25-50%

Negotiated prices

Usually market or cost is the starting point for negotiations

Usage Patterns

LO5: Describe transfer pricing


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Corporate tax planning affects where to recognize income

Incentives can also arise because of

Competitive reasons

Subsidies

Regulatory reasons

Restrictions on capital flow

Tax planning incentives can override other issues (e.g., providing best economic signals) when setting transfer price

International Transfer Prices

LO5: Describe transfer pricing


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Governments recognize corporate incentives\

Impose extensive rules and regulations on what is allowed

Could impose sanctions

Penalty for dumping

Tariffs

Setting transfer prices to optimize the various tensions is a very difficult exercise

Rules & Regulations

LO5: Describe transfer pricing


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Game playing means profitable transfers might not take place

Sub-optimization

Should HO intervene?

Feasibility is an issue

Need detailed information about operations

Gains surplus by forcing transaction

Undercuts benefits due to decentralization

Intervention

LO5: Describe transfer pricing


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Appendix

TRANSFER PRICING


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Selling Division

Value = TP- Controllable cost

Value ≥ Opportunity cost

TPMIN = Controllable cost + Opportunity cost

Buying division

TPMAX= Opportunity cost

Acceptable Transfer Prices

Appendix


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TPMAX = TPMIN

No surplus from transfer

Corporate does not care

At the one agreeable price, divisional profit the same with or without transfer

Competitive market for transferred item

Congruence between divisional and corporate objectives

TPMAX < TPMIN

Negative surplus from transfer

Corporate does not want transfer

Divisions cannot agree on price

Congruence between divisional and corporate objectives!

Three Cases

Appendix


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TPMAX >TPMIN

Surplus from transfer

Surplus = TPMAX – TPMIN

There is a price at which both divisions are willing to voluntarily enter transaction

Congruence between divisional and corporate objectives

Three Cases

Appendix


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For the chip division, the contribution margin from an external sale = $18.00 per chip and the controllable cost = $12.50 per chip. Thus, TPMIN = $12.50 + $18.00 = $30.50 per chip. For the phone division, TPMAX is still $32 = $52 total variable cost of buying externally - $20 variable phone cost of buying internally. Thus, the range of acceptable transfer prices is $30.50 to $32.00. If the transfer price is set anywhere in this range, the company as a whole saves $1.50 for every chip that is internally transferred.


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Exercise 12.31

Responsibility accounting (LO1, LO2)

Karl Krader oversees a staff of over 200 persons and a budget of close to a million dollars per year. He is responsible for the upkeep of all buildings and equipment at a large university. However, any reconstruction project is budgeted and administered separately. Karl’s responsibilities include selection and evaluation of personnel, negotiating with suppliers, choosing the kinds of landscaping, and so on. Karl’s services, however, are

  • Required:

  • Should Karl be evaluated as a profit center or a cost center?

  • How should the university evaluate Karl’s performance?


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Exercise 12.31 (Continued)

  • Should Karl be evaluated as a profit center or a cost center?

We believe that Karl should be evaluated as a cost center. While he provides a useful and visible service, there is no direct impact on revenue. Further, he does not influence prices or determine the level of output. His job is to keep up the buildings to specified quality levels within allowed costs. This is a central characteristic of a cost center.


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Exercise 12.31 (Concluded)

  • How should the university evaluate Karl’s performance?

The university should use a mix of financial and non-financial measures. Relying on financial measures alone is not advisable because Karl can always postpone maintenance to come in below budgeted expenditures. However, we do need to make sure that the budget is not over-spent by a lot. Non-financial measures such as time to respond to complaints and general score on upkeep seem useful as a way to make sure that Karl is providing the desired service quality.


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